ISM Reports Help Create Nervous Investors

Over the past couple of weeks, U.S. equity markets have been volatile. While geopolitical risk, especially in the Middle East and in Ukraine, has been at the forefront of investors’ minds, strong economic readings have also played a role. Their concern centers on the fact that stronger economic data may cause the Federal Reserve to raise interest rates faster than anticipated. With the U.S. economy having already shown signs of being on a more solid footing than just a couple of years ago, why have investors reacted with such concern over the most recent data reports released over this past week? The ISM Services Index and the ISM Purchasing Managers Index offer economists the first look at the prior month’s economy.

Coming out of the Great Recession, the U.S. economy has provided many head fakes to prognosticators and market experts. Many times over the past few years, the economy seemed to be developing momentum, however, in the end, these proved to be short-lived. However, as shown in the table below, over the past two years, many underlying components that comprise economic output have shown strength.

June 2012 Data

June 2014 Data

Motor Vehicle Sales (Annualized)

14.0 mil

16.7 mil

Average Increase in Monthly Payrolls

80,000

217,000

Unemployment Rate

8.2%

6.3%

New Home Sales

346,000

433,000

Source: BEA, BLS, JP Morgan, Cetera Research (2014 Mid-Year Outlook)

So with the economic data clearly picking steam over the past couple of years, why have investors seemingly acted so surprised at the data reports released over the past week? The ISM indices offer one of the first looks at how strong or weak the economy was in the prior month.

The Institute of Supply Management (ISM) creates monthly indices compiled from a questionnaire of executives who buy supplies for their companies. Readings over 50% signal that more businesses are expanding instead of contracting. Their two primary indices, Purchasing Managers Index (PMI) and Services Index, were released on August 1st and August 5th respectively and both showed a jump in economic activity for July. The overall ISM PMI rose to 57.1%, its highest level since April 2011, while underlying components of the index were also strong — new orders rose 4.5 points to 63.4%, production edged to 61.2% and employment jumped to 58.2% (the highest rate of employment since April 2011). 17 of the 18 manufacturing industries surveyed in the report reported growth. Similarly, the ISM Services Index rose in July to 58.7%, marking the highest level since December 2005. As noted by the ISM, both manufacturing and services readings offer more evidence that the economy is shifting into a stronger phase of growth.

With economic activity on the upswing, which would seemingly be good news for equity investors, these reports have instead generated the exact opposite — anxiety and concern. With the bond market expecting the Fed to not raise rates until mid-2015, these readings, along with a solid July payroll report also released last week, suggest that the Fed may need to raise rates sooner than expected in order to curb inflationary pressures. Whether or not the Fed hastens its decision to raise rates, tensions are rising among its members. In its statement last week, the Fed did not hint at the timing of a rate hike, repeating that interest rates would likely remain close to zero for a “considerable time” after the end of the central bank’s bond-buying program (quantitative easing), expected in October. While the majority on the Fed thinks the economy needs more time to heal, a growing minority at the Fed, in particular Charles Plosser, president of the Philadelphia Fed and a known proponent of higher interest rates, thinks that the Fed should begin to raise interest rates or risk higher inflation. These strong economic readings and rising tension among Fed members has unnerved investors, contributing to the recent market volatility that we have seen.

We believe that with the economy showing a solid footing, higher yields, whether caused by the Fed actually raising rates or bond investors anticipating this Fed action, are likely. To help mitigate against this scenario in portfolios today, we continue to recommend less interest rate sensitivity (i.e. lower duration), increased diversification, and a bias toward non-Treasury bonds (such as corporate bonds). Also, alternative investments are an option as they have historically offered a return stream different than traditional investments.

This information is compiled by Cetera Investment Management.

About Cetera Investment Management

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No independent analysis has been performed and the material should not be construed as investment advice. Investment decisions should not be based on this material since the information contained here is a singular update, and prudent investment decisions require the analysis of a much broader collection of facts and context. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The opinions expressed are as of the date published and may change without notice. Any forward-looking statements are based on assumptions, may not materialize, and are subject to revision.

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